One rule of thumb regarding the ownership of company stock suggests that 10-15% of your total net worth may be a suitable allocation. 10-15% allows an employee or shareholder to participate in the upside of the company should the stock appreciate and, perhaps more importantly, be somewhat insulated from the risk of total wealth destruction should the company underperform and lose its value precipitously (yes, it is possible and this can definitely happen).
Even so, I find many investors who break this suggestion and exceed the rule of thumb. Sometimes, the decision to exceed the rule is intentional. Other times, the substantial allocation to one company stock is forced.
Intentional ownership can include buying stock outright, through an employee stock purchase plan, or in an employer-provided 401(k) plan. Forced ownership, on the other hand, may include the grant of restricted stock, non-qualified stock options, or incentive stock options.
Ultimately, as more and more ownership is purchased (given), it’s entirely possible that a greater percentage of one’s net worth becomes concentrated in a single equity position (anti-diversification*) and the risk of major gain and loss likely increases.
This begs the questions, at what point is it best to unwind a concentrated equity position? Furthermore, what is the best strategy to diversify* a large allocation of company stock into other holdings? Should I recognize ordinary income now or defer it until later? Do I have stock with a basis that is equal to the market value of the stock that I can liquidate with little or no tax consequences? Do I have stock at a loss? Should I exercise and hold options to take advantage of long-term capital gain rates in the future?
As you can likely assume, there is no completely “right” answer to these questions.
However, it is possible to unpack and divide this multifaceted problem in order to identify possible solutions. One such issue is to address the tax implications of said reallocation. Tax, as it pertains to the liquidation of various types of employer stock holdings, can be wildly different.
For that reason, it makes sense to not only understand your investment goals and objectives, but also to understand the potential tax implications of each type of stock ownership before deciding which of your shares to liquidate.
Tax on Outright Ownership of Company Stock
One simple strategy to accumulate company stock is to purchase it on the open market through a brokerage account or other investment account. When you purchase a stock, the price you pay for the stock is known as the basis. All future tax implications will be calculated from the basis.
When selling company stock that was purchased outright, you should be aware of a few things. First, you should be aware of both the short-term and long-term capital gains. Short-term capital gains (losses) will be recognized if you sell the shares within 1 year of the date of purchase. Long-term capital gains (losses) will be recognized should you sell the shares after 1 year from the date of purchase.
Short-term capital gains are taxed at ordinary income rates, and ordinary income will be taxed at your marginal tax rate. Long-term capital gains are subject to preferential long-term capital gains rates, potentially as low as 0%, but more commonly 15%.
Depending on how long you have held the stock, and how much gain or loss is unrealized, selling shares that are owned outright may be your best strategy that keeps your tax liability lower, while also decreasing your total allocation to company stock.
Tax on an Employee Stock Purchase Plan
When you purchase the shares of stock, there is no tax implication. Taxes, on the other hand, are owed when you sell the shares. How much tax, and what type of tax depend on a number of things.
Generally, when you sell shares of an employee stock purchase plan, the value of your discount at purchase may be considered compensation and be taxed as ordinary income. The amount of gain or loss over this amount will be taxed as a capital gain subject to capital gains rates and holding periods (short term vs. long term – see outright ownership).
Tax on Restricted Stock
Restricted stock is different from other forms of stock ownership, in that the owner may have a limited ability to control when they are required to report income, and therefore pay taxes.
With restricted stock, no taxes are owed when the shares are granted (unless you elect an 83(b) election). Eventually, the shares will “vest.” When the restricted stock vests, the recipient of the shares is required to report the value as ordinary income. The amount reported as ordinary income is equal to the total market value of the vested shares (taxable amount = amount of vested shares multiplied by the share price).
Assuming no 83(b) election was chosen, the shareholder has no control over this taxable event. They do have control, however, of whether to exercise a cash exercise or a cashless exercise.
After the shares have vested, the shares have a basis that is equal to the taxable amount reporting as ordinary income. Moving forward, the shares look and act like outright ownership, as mentioned above. If the shares are sold in less than 1 year, short-term capital gain rates apply, and if they are held for longer than 1 year, then long-term capital gain rates apply.
Tax on Non-Qualified Stock Options
Unlike restricted stock, which limits control over when to recognize income and tax, Non-Qualified stock options allow the shareholder to control the tax impact (within the period prior to the option’s expiration date).
Non-qualified stock options are issued with an exercise price. The exercise price is the price at which the option holder can buy the shares (assuming they have vested). Should the market value exceed the exercise price, the owner of the stock options is “in-the-money” and can exercise their option. Should the market value of the stock be below the exercise price, the options have no value and may likely continue to go unexercised.
If the option holder chooses to exercise the option, ordinary income will be recognized on the value between the exercise price and the market price. This amount will go on the tax return and be taxed at the option holder’s marginal tax rate.
For example, let’s assume that 1,000 shares of XYZ stock are granted with an exercise price of $5. Let’s further assume that in 3 years, the market price of XYZ stock is $40 per share. In this hypothetical example, the recipient of the options has an “in-the-money” stock option with a value of $35 per share, or $35,000 in total. If exercised, $35,000 will flow through to the tax return as ordinary income (this $35,000 is technically known as the compensation element).
The option holder could, however, choose not to exercise the option and continue to “defer” the recognition of tax.
Non-qualified stock options are favorable, in that the shareholder can control when the income is recognized. They can exercise the option, or they can wait.
Should they be in a tax year with a high income, it may make sense to not exercise. Should they be in a tax year with a low income, exercising the options and reporting income at a lower rate may be better.
After the shares are exercised and owned outright, all further income recognition and taxes owed act like outright ownership, as detailed in Option 1, specifically short-term capital gain (loss) or long-term capital gain (loss).
Taxation of Incentive Stock Options
Incentive stock options are by far the most challenging in terms of income recognition and subsequent taxation. Depending on the timeline between when shares are granted, exercised, and resold on the open market, there may be any number of taxes that need to be paid. Specifically, tax on incentive stock options may include ordinary income tax, long-term capital gains tax, and/or the alternative minimum tax (AMT).
While certainly more complicated, incentive stock options may present a better opportunity for well-informed holders of the stock options. If exercised strategically, and by following a specific set of rules, a shareholder can take advantage of long-term capital gains rates on the value between the exercise price and the market price at final sale (long-term capital gains rates may be the difference between paying 15% or 33% on the gain).
Incentive stock option holders may act in one of the following ways when exercising and subsequently selling their stock. The tax impact for each of these scenarios is beyond the scope of this article (but an article on this is coming soon).
- Exercise your shares and hold them
- Exercise your shares and sell them within 1 year
- Exercise your shares and sell them within 1 year, but during the following Calendar Year
- Exercise your shares and sell them after 1 year, but within 2 years of the Grant Date
- Exercise your shares and sell them after 1 year, and after 2 years of the Grant Date
What Does This All Mean?
Unwinding a concentrated stock position efficiently requires planning. A good strategy to unwind concentrated equity should consider both short- and long-term tax implications, current financial conditions, future financial expectations, all the available holding positions, and a shareholder’s overall investment goals and objectives.
While we never want to be the proverbial tail wagging the dog (taxes driving our investment decisions), in this case, taxes and investments both need to be considered in order to make the best decision.
*Asset allocation or diversification do not guarantee a profit or protect against loss.
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation. Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts
The above hypothetical examples are for illustrative purposes only and do not attempt to predict actual results of any particular investment.